The Hawk Talks

Andrew Sentance’s economics blog

This page hosts Andrew Sentance’s economics blog. If you came here looking for the big band classic “The Hawk Talks” by Duke Ellington, click here for a recording by The Brentwood School Big Band.

I am also now posting articles on the PwC “Economics in Business” blog, where you can read the views of my PwC colleagues as well as my own.

Click here to access the PwC Economics blog.

We should not be so scared of deflation

posted by Andrew Sentance, 4 March 2015

Consumer prices are falling in the Eurozone and the US and inflation is very low in the UK. This has led to renewed concern about the perils of deflation.

Deflation has aggravated and compounded very negative economic situations in the distant past. In the UK, prices fell by over 25% between 1920 and 1923 and continued to fall more slowly for a further 10 years. Average UK economic growth in the 1920s was just 0.7% – the worst growth decade for the British economy since the early 19th century, accompanied by very high unemployment which continued into the 1930s.The US also experienced severe deflation in the Great Depression, with prices falling by about a quarter between 1929 and 1933. This too was a period of widespread financial distress and very high unemployment.

These deflationary episodes were very severe. Not only were consumer prices falling sharply but  money values in many other areas of the economy were declining at the same time – wages, the value of spending, property prices and the stock market. A widespread fall in prices and values in an economy creates a very negative mood in terms of confidence, investment and the view of future prospects. It creates severe financial distress as firms and individuals may not be able to service debt when their incomes are falling. And the impact of declining asset values on personal wealth depresses spending.

Since the Second World War, we have not seen a similar extreme scenario in any major economy. There was a danger that severe deflation could have been triggered by the Global Financial Crisis in 2008. But that risk was countered by a combination of economic and financial policies deployed worldwide – slashing interest rates, Quantitative Easing, increased public spending, tax cuts and direct interventions into the financial system to prevent banks failing. These responses enabled most western economies to get back on a growth path from mid-2009 onwards – even though growth rates have been generally disappointing in the “New Normal” post-crisis world.

Japan is cited as the most notable example of deflation in recent times. Consumer prices fell in Japan from 1999 until 2005 and again from 2009 to 2012. But deflation was mild – consumer prices fell by more than one percent in only one year (2009) and the average annual decline in prices between 1998 and 2012 was just 0.3%.  GDP declined in money terms in 9 out the 14 years 1998 to 2011 – but again this was a slow rate of decline, averaging less than 1% a year. The Japanese economy continued to grow sluggishly in real terms – with average GDP growth of 1.5% in the eight years following the Asian crisis (2000-2007).

The unemployment rate in the early 2000s was high by Japanese standards – peaking at around 5.5% in 2003 before falling back to below 4% before the financial crisis and dropping to around 3.5% more recently. But this is a far cry from the mass unemployment which the UK, US and other European economies experienced between the two World Wars.

Deflation is widely blamed for disappointing growth in the Japanese economy from the 1990s onwards. But there much more important factors have contributed to Japan’s low growth on the supply-side of the economy: slow progress in dealing with banking problems; a declining workforce due to an ageing population; low female participation in the labour market; sluggish productivity growth in the services sector; and the reluctance of Japan to open up its economy to international competition and overseas investment. If anything, Japanese deflation was a by-product of these problems because they contributed to a negative view of investment and economic growth prospects.

With annual inflation now negative for three consecutive months in the Eurozone, some economists have been quick to draw parallels with Japan and raise the spectre of damaging deflation. Euro area consumer prices fell by 0.6% in the year to January but the rate of decline has eased to 0.3% in February. The decline in the value of the euro against the dollar has probably helped to stem the rate of price decline in the Eurozone.

The most likely scenario is that the euro area will not stay in deflation for long. Excluding falling energy and food prices the euro area inflation rate is relatively stable and positive – at 0.6%. Growth is picking up, unemployment has fallen to its lowest level for nearly three years, the euro has been falling against other currencies – encouraged by the ECB’s QE programme – and the oil price has recovered somewhat. It does not appear that deflation in the euro area will be a serious or persistent economic problem.

Indeed, if we look at European economic performance at the national level, it appears that the countries with the biggest falls in prices are doing relatively well in terms of growth. Seven countries have seen a consumer price fall of 1% or more in the past year – Greece, Bulgaria, Spain, Lithuania, Hungary, Luxembourg and Poland. Only 4 of these 7 are euro area members. And the average rate of growth in these seven economies in the past year has been 2.5%, around double the average EU growth rate of 1.3%.

Mild deflation driven by a fall in the oil price and declines in the cost of other imported goods can help economies. A period of falling prices can support the growth of household incomes in real terms when wage growth is low, boosting consumer spending. In the year ahead, the oil price fall should also be a positive factor for economic growth in the Eurozone, and forecasts are now being uprated accordingly.

If there is a parallel which we need to draw between Europe now and Japan in the 1990s and 2000s, it is how the slow progress of economic and financial reform can hold back growth and create a very negative business and investment climate. That is the key issue which policy-makers in Europe now need to address, particularly in Italy and France – the worst performing large euro area economies, which account for nearly 40% of Eurozone GDP.

We need to change our view of deflation. Occasional and mild periods of falling prices should not be feared. An extreme deflationary scenario was successfully avoided in the aftermath of the Global Financial Crisis. Now that danger has passed, the focus needs to shift to improving the supply-side performance of economies to support growth.

Have the lions of Central Banking lost their roar?

posted by Andrew Sentance, 28 February 2015

These are tough times for bankers in the private sector. They are no longer the “masters of the universe” that they appeared to be in the mid-2000s. In many countries, banks are grappling with underperforming loans, shrinking balance sheets, financial scandals and – in some cases – the need for substantial government support. Bankers are widely blamed for the problems the major western economies have encountered since 2007.

By contrast, their official counterparts – Central Banks – are riding high. Central Banks have been the institutions which have come to the rescue in dark and difficult times. They have slashed interest rates, pumped vast amounts of money into the financial system and worked with governments to rescue banks and support lending. They have acquired new regulatory powers – particularly here in the UK where the Bank of England has become a financial “super-regulator” alongside its traditional responsibilities for monetary policy.

Central Banks have become the new masters of our economic universe – but that should make us wary. Just as we had too much confidence in private sector bankers before the financial crisis, we risk putting too much faith in the power of Central Bankers.

The ability of Central Banks to act powerfully through the financial crisis and in its aftermath has rested on two mutually reinforcing foundations: independence and credibility. These foundations were laid in the two decades following the previous big financial crisis in the mid-1970s. When inflation got out of control in many countries, independent Central Banks came to the rescue and enhanced their credibility in the process.

The pioneer was the Bundesbank, whose traditions and history underpin the operation of the European Central Bank. In the 1970s, the Bundesbank pursued tight monetary policies when other countries were prepared to accommodate inflation. The relative success of the West German economy under these policies helped build the reputation for independent Central Banks with a commitment to price stability.

The US Federal Reserve under Paul Volcker followed suit in the 1980s. Having accommodated inflation in the 1970s, the Fed re-asserted its independence using high interest rates to restore price stability. The UK emulated these policies under the government of Margaret Thatcher. But control over inflation in the UK was lost in the late 1980s and had to be restored in the early 1990s. This led ultimately to the establishment of the Bank of England as an independent monetary authority in 1997, with control over interest rates exercised by the Monetary Policy Committee.

Independent Central Banks with a credible commitment to price stability held sway through the 1990s and the 2000s. And when the euro came into being, the ECB was established on the model of the Bundesbank. Whenever economic growth showed signs of faltering, Central Banks were prepared to reduce interest rates to support economic activity. They did so after the Asian crisis, and when the “dotcom bubble” burst in the early 2000s. Financial markets came to believe in the “Greenspan put” – whatever happened, the US Federal Reserve would act to sustain growth. And other Central Banks in the western world pursued similar policies.

The actions of Central Banks through the financial crisis have followed the same pattern. In the words of ECB Governor Mario Draghi, they have been prepared to do “whatever it takes” to support their economies. This has included turning a blind eye to relatively high inflation, as we saw in 2011/12.

At the same time, Central Banks have accumulated new responsibilities. They have worked with governments to intervene in the financial system to rescue banks. They have developed new financial tools: Quantitative Easing and “macroprudential policy” – using bank regulation rather than interest rates to steer the economy. And they have acquired new regulatory powers on both sides of the Atlantic.

But there are potential downsides to these developments.  First, the hard-won independence of Central Banks is being diluted.  By acting as instruments of government policy – for example  through Funding for Lending in the UK or the ECB’s participation in the Troika supervising the restructuring of the Greek economy – the dividing lines between government policy and Central Bank action are becoming increasingly blurred. The fact that Central Banks have become substantial holders of government bonds adds to these concerns.  The effect of Quantitative Easing is that government spending is financed by money creation rather than issuing debt on the financial markets. This is justifiable as a short-term remedy to restore financial confidence but not as a long-term basis for managing our public debt.

Second, Central Banks – which have won their credibility as the champions of stable prices – now seem to be trying to create inflation, not subdue it. There appears to be a desire in the US, UK and the rest of Europe to get inflation back to 2% – which may not be justifiable or necessary. There is nothing sacrosanct in a target of 2% inflation – it is an approximation which served policy-makers well as a definition of price stability when they felt that zero inflation was not achievable. But price stability could mean what it says on the tin- somewhere close to zero, perhaps as close as possible. A distinction needs to be made between temporary periods of deflation – as the euro area is now experiencing – and a chronic deflation which the US experienced in the 1930s and the UK experienced in the 1920s.

Third, we are in danger of overloading Central Banks with so many responsibilities and duties that they will be bound to fail in some area – undermining their credibility. Just as with the private sector banks – which overstretched themselves a decade ago – this “mission creep” risks distraction and a loss of focus on core responsibilities, including price stability.

These concerns are not just theoretical – they appear to be influencing the approach to managing the exit from the very stimulatory monetary policies put in place to combat the financial crisis. Maintaining financial and price stability in well-performing economies like the UK and US should require a gradual rise in interest rates. But both the Fed and the Bank of England are extremely cautious in their approach to this challenge. We may regret this cautious approach in the future if the required interest rate rises are imposed quickly and abruptly because monetary policy has got “behind the curve”.

Independent Central Banks need to be prepared to take measures which politicians can’t or won’t take. But the current generation of central bankers risks being distracted by their new and extended responsibilities and by their increasingly political and complex role. The lions at the heart of our financial system have lost their roar.

This is an expanded version of an article published in the Financial TImes on 28th February 2015

The “productivity puzzle” – it’s the New Normal!

posted by Andrew Sentance, 28 June 2014

There has been much discussion of the “productivity puzzle” in the UK economy since the financial crisis. Despite a five-year recovery which has been underway since mid-2009, GDP per worker and output per hour worked are still about 4% down on early 2008 levels. Productivity fluctuates with the cycle, but it normally rebounds as the economy recovers. That has not happened in the UK following the financial crisis.

But this is not just a problem for the British economy. It is part of a wider productivity slowdown affecting the West more generally. As the Chart below shows, among the 8 leading western economies, only two – the US and Spain – have shown meaningful productivity growth since 2006 (the year before we began to feel the effects of the financial crisis). The UK is in the middle of this sluggish pack, ahead of Germany, Italy and the Netherlands but behind Canada and France.

Even in Spain and the USWestern productivity since 2006 the story is not that reassuring. Spanish productivity stagnated and declined for most of the 2000s. So the recent surge is a recovery from this disappointing period. If we take the fifteen years from 1999 to 2014, the average rate of productivity increase in the Spanish economy has been a very disappointing 0.7% per annum. The US story is a bit more encouraging, but even here average productivity has increased by just over 1% a year since 2006, about half the rate seen before the crisis.

The “productivity puzzle” is therefore not just a UK phenomenon. It is affecting all the major western economies to some degree. So we need an explanation which is not just UK-specific, but which relates to our peer group of North American and European economies as well.

In my view, the answer lies in understanding why growth and productivity did so well in the West before the crisis. In my recent book, Rediscovering growth; After the crisis, I argue that three powerful tailwinds contributed to a long expansion of western economies going back to the 1980s, which was only briefly interrupted by the early-90s recession. The first was the availability of “easy money” based on a deregulated and increasingly globalised financial system. The second tailwind was an era of relatively cheap imports, with low energy and commodity prices prevailing from the mid-80s to the mid-2000s. This was reinforced by the “China effect” as the shift of manufacturing to low-cost economies pushed down the cost of many goods bought by western consumers, including clothing and electronic devices.

The third tailwind was a feeling of confidence that governments and Central Banks could keep our economies on a steady and even growth track, by changing interest rates or adjusting spending and tax policies.

All these tailwinds have disappeared as the result of the financial crisis and as the era of low fuel and commodity prices has given way to a much higher price world for globally traded energy, raw materials and food. And we should not expect a similar set of tailwinds to resume soon.

That implies that part of the productivity slowdown we have seen across the West is long-term. If productivity and growth were inflated by a set of forces which have now gone away, the New Normal will be a world of lower productivity growth. As the economist William Baumol pointed out in the 1960s, as economies become more services-oriented and less dependent on manufacturing industry we should expect the productivity growth rate to decline. All the major western economies are now highly service-oriented, and this is particularly true of the UK where manufacturing is just around 10% of GDP and employment in industrial sectors is just 8% of the total.

But we may have seen an exaggerated productivity slowdown since 2008, as our economy has had to absorb the shock of the financial crisis and adjust to a regime of higher energy prices and more uncertainty. A similar set of shocks created a sharp productivity slowdown in the western economies in the 1970s, from which they gradually recovered in the 1980s. So we should not become excessively pessimistic about longer term productivity trends based on the past few years.

In the UK, we should not beat ourselves up too much about our productivity performance. As the chart shows, British productivity performance since 2006 has been better than a number of other European nations, including Germany. The productivity slowdown is a phenomenon affecting all western economies to some degree.

As our economy adapts to the New Normal post-crisis economic climate, productivity growth should gradually recover, but not to the rates we saw before 2007. With the UK economy set to top the G7 growth league in 2014, there are encouraging signs that this adjustment is underway. But the favourable pre-crisis tailwinds of easy money, cheap imports and confidence in policy-makers are not set to return quickly, if at all.

You can find earlier posts from The Hawk Talks blog on my old website: